The ancient language of Latin includes many time honored phrases that are still as relevant today as when they were written, despite thousands of years of technological progress. It appears that no amount of recorded history can stop Human Beings from repeating almost the exact same investment errors, sometimes within only a few years of each other.
Despite all the publicly available info from stock market/investment historians, and from numerous well celebrated books about investing, the same basic emotional weaknesses cause investors to continuously repeat past errors.
The most powerful emotions relating to investing are fear and greed. Investors tend to be fearful when a stock, or the entire market declines, and greedy after those same investments have increased dramatically.
Why Investments become over Valued
The first thing to understand is that when investments become overvalued, they can stay that way for many years. Over time, most investors tend to become comfortable with an overvalued investment landscape, which causes them to rationalize ever increasing valuations. The residential real estate bubble is a perfect example. Investor complacency, leads to greedy behavior, but this can only be seen at the time by a few older and wiser professionals. Most mutual fund managers feel compelled to invest in an overvalued environment, because of short term competitive pressures. Technological advancements tend to make people feel that they can exit before disaster strikes. Since almost all investors have access to the same short term news, everyone cannot sell at the same price, because the old buyers are also trying to sell. Then the greed can turn to fear, causing investment prices to decline dramatically.
Signposts that others are being Greedy
1) One clear sign of greed occurs when some of the best performing stocks are rising because the multiple of sustainable earnings is being inflated, rather than because of large increases in actual earnings. Most of the underlying stocks in the Biotech index (NASDAQ:IBB), have increased on investor optimism, and not based upon actual large earnings increases. As detailed in my recent Seeking Alpha blog post, Amazon (NASDAQ:AMZN), Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), Salesforce.com (NYSE:CRM) have risen dramatically over the last few months and/or years and now sell at nose bleed multiples of realistic forecasts of next year's earnings.
2) In the last few months, new issues are again rising dramatically on the first day of trading. When investors are so desperate to buy into newly public companies at large percentages above the issuing price, this behavior has historically been a strong sign of speculative market psychology. Traditionally a hot new issue market after the general market has been rising for many months and/or years, is not the time that stocks in general offer good value.
3) Extremely low interest rates provide fuel for speculative behavior and overvalued markets, that tends to cause people to act greedy. While the US Federal Reserve Bank (the FED) is currently targeting an inflation rate at 2% or less, short term interest rates are at practically zero today. Historically, US Government short term interest rates tend to be slightly above the prevailing inflation rate, or else inflation tends to accelerate above an acceptable level. Therefore, the FED will eventually be forced to raise short term interest rates up to approximately 2% or more. Furthermore, the FED has been engaging in quantitative money policies, by buying $85 billion of longer term bonds each month. The lower than normal longer term interest rates are forcing investors into buying higher yielding stocks, because of the unnaturally low interest rates on longer term bonds. While most investors are aware that the interest rates will go up after the FED stops their abnormal activities, short term competitive pressures and greed have created numerous overvalued stocks.
Investors should be raising cash from selling clearly overvalued stocks. Raising cash levels now, will position investors so they can buy some of the bargains that will inevitably emerge, after the current cycle of greed turns to fear. Tax loss selling season starts in only 5 weeks or so, and will probably provide a few bargains by the end of this year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.